Why Reported Inflation Seems Different Than Reality

The subject of inflation has remained an emotionally charged topic of debate over the last several years. As rising prices for individuals, and businesses, has negatively impacted their prosperity; reported inflation has remained at very low levels. With the Fed pumping trillions of dollars into financial system the fear of much higher inflation, as the dollar is debased, has caused gold prices to soar in recent years. As we will discuss momentarily, the issues surrounding government spending, and the massive deficit, has brought the topic of inflation to the forefront of the political debate.

However, a bit of history is needed for context. The government produces a measure of inflation called the consumer price index (CPI) which is generally broken down into two reports: Headline and Core. The only difference between the two measures is that the core reading strips out the volatile food and energy components. It is this core reading that economists, and the Fed, focus on much to the aggravation of average consumers who quickly point to the fact the food and energy are big part of their daily lives.

The sole purpose in measuring inflation is to help businesses, individuals and government adjust their financial planning for the impact of inflation. Inflation erodes future purchasing power, and decreases economic prosperity, if not accurately accounted for. The accuracy of measuring inflation, and accounting for it properly, is essential to long term economic prosperity.

The original calculation of CPI, which measured the change in the cost of an identical fixed basket of goods priced at prevailing market costs each period, worked reasonably well for the intended purpose into the early-1980’s. However, as the pressure of increasing deficits weighed on political parties, the need to find solutions to reducing spending, without actually cutting spending, led to several substantial changes in the calculation of inflation.

Shortly after Clinton entered the White House the Bureau of Labor Statistics (BLS) altered the calculation of inflation by changing the weighting of goods in the CPI fixed basket. Then, over subsequent years, the method of weighting the underlying components was changed from a straight arithmetic weighting method to geometric. The primary result of the switch to a geometric weighting was a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price which led to lower reported inflation.

“…the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third.”

But the manipulation of the data did not stop there. Aside from the weighting changes the BLS instituted a system of “hedonic” adjustments. Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from them.

“That new washing machine you bought did not cost you 20% more than it would have cost you last year, because you got an offsetting 20% increase in the pleasure you derive from pushing its new electronic control buttons instead of turning that old noisy dial, according to the BLS.

When gasoline rises 10 cents per gallon because of a federally mandated gasoline additive, the increased gasoline cost does not contribute to inflation. Instead, the 10 cents is eliminated from the CPI because of the offsetting hedonic thrills the consumer gets from breathing cleaner air. The same principle applies to federally mandated safety features in automobiles. I have not attempted to quantify the effects of questionable quality adjustments to the CPI, but they are substantial.”

Lastly, there is "intervention analysis" in the seasonal adjustment process. Intervention analysis is critical to the highly volatile areas of food and energy. When a commodity, like gasoline, goes through periods of violent price swings the BLS steps in and uses “intervention analysis” to smooth out the volatility. As a result, sharply rising gasoline prices are never fully reflected in the reported headline inflation number. However, declining prices, which are never adjusted, do show an impact to reducing inflation.

The obvious problem with these manipulations is it changed the measure of inflation from a cost-of-living adjustment to a reduction-of-living adjustment. The original CPI calculation allowed individuals to understand the rate of return required on investments and incomes to maintain their current standard of living. However, by artificially suppressing the rate of inflation, the future standard of living is reduced to lower levels.

The chart above shows the original calculation of inflation (which was based on a basket of goods), data sourced from John Williams, versus the current measure of CPI. It is quite apparent that inflation, as reported by the Consumer Price Index (CPI), is understated by roughly 7% per year.

The deviation between the two measures is strictly due to the redefinitions of the series and adjustments to price measures utilized. These changes to the CPI have detached the cost-of-living adjustments from the real cost-of-living experienced by those dependent upon a fixed income stream for survival.

According to John Williams:

"In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations have reduced current social security payments by roughly half from where they would have been otherwise. That means Social Security checks today would be about double had the various changes not been made. In like manner, anyone involved in commerce, who relies on receiving payments adjusted for the CPI, has been similarly damaged. On the other side, if you are making payments based on the CPI (i.e., the federal government), you are making out like a bandit."

This is why the average American has repeatedly lashed out at the current measure of inflation as it doesn't represent the inflation rate that they are personally experiencing. Rising food and energy costs are consuming more and more of a declining level of incomes. For those individuals dependent on a fixed stream of welfare payments the lower rate of inflation adjustments, while putting more money in the coffers of the government, has led to a steadily declining standard of living for the elderly.

The Chained CPI “Fiscal Cliff” Farce

In the latest attempt to save the economy from the "fiscal cliff" a grand bargain is being crafted that will possibly include a relic from the debt ceiling debate in 2011 called "Chained CPI." As with the Clinton Administration, once again the need to reduce government spending has given rise to a proposal to further suppress the measure of inflation to reduce the cost of living adjustments for social security recipients. The issue with "Chained CPI,” as with the current measure of CPI, is that it will further misrepresent what the average consumer is living with from day to day.

“Economics and policymakers generally make the assumption that when prices rise, people will turn to a less expensive product. They’ll buy chicken instead of more expensive beef, iceberg lettuce instead of arugula, store-brand, instead of name-brand cereal. The chained CPI attempts to account for how people react to inflated prices.

It’s an arcane detail in the ongoing budget debate, but the chained CPI is appealing to budget experts and some Republicans and Democrats, because it only slightly tweaks the inflation formula, while building significant savings over time, perhaps more than $100 billion over a decade.

Making such a change also means paying out less in Social Security benefits over time — something liberal Democrats can’t stomach. Imagine, for example, a person born in 1935 who retired to full benefits at age 65 in 2000. People in that position had an average initial monthly benefit of $1,435, or $17,220 a year, according to the Social Security Administration. Under the cost-of-living-adjustment formula and 2012 inflation, that benefit would be up to $1,986 a month in 2013, or $23,832 a year. But if payouts were adjusted using chained CPI, the sum would be around $1,880 a month, or $22,560 a year — a cut of more than 5 percent and more as the years go by.”

When it is known in advance that tweaking the math will create a "permanent" reduction in the measure of inflation then it is no longer an accurate assessment of inflationary pressures in the economy. If adopted across the government, the change would have far-reaching effects on the many programs that are adjusted each year based on year-to-year changes in consumer prices.

The groundswell of aging “boomers” that will are rapidly approaching the point of become welfare program recipients will find that the fixed stream of income payments will not be sufficient to maintain their current standard of living in the future. This will continue to push an ever aging population into working much longer into their retirement years.

Furthermore, a side effect of artificially suppressing inflation is that taxes would slowly increase because annual adjustments to income tax brackets would be smaller. This would eventually push more people into higher tax brackets allowing fewer people to be eligible for anti-poverty programs like Medicaid, food stamps and school lunches. While the annual adjustments will eventually remove individuals from poverty on a statistical basis – it doesn’t mean that would be any more capable of supporting themselves.

Lastly, one reason why there has been such a disconnect between reported GDP, and the way that average Americans feel about the economy, is due to the way CPI affects the GDP calculation. Although the CPI is not used in the actual GDP calculation, there are relationships with the price deflators used in converting GDP data and growth to inflation-adjusted numbers. The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported. The problem is that real inflationary pricing pressures is simultaneously eroding the real prosperity of the average consumer.

While going to "Chained CPI" will save the government over $100 billion during the next decade in payments to individuals - this is not a good thing for those dependent upon those payments. Furthermore, the assumptions for budgeting will also be grossly flawed which means that when we get to the end of this decade it is likely that we will be in worse shape than was estimated. Hopefully, those in Congress will opt not to further suppress the inflation calculation for political gain at the expense of the average American.

In the coming weeks ahead, in collaboration with my friend Doug Short, we will be introducing an inflation index which will be reconstructed along the same lines as the original form of CPI using an arithmetically weighted calculation on a fixed basket of goods. It is hoped that from this experiment we can establish a baseline from which we may be able to ascertain the actual impact of the current environment on incomes, spending and the economy. Stay tuned.

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of "Street Talk with Lance Roberts", Chief Editor of "The X-Factor" Investment Newsletter and the Streettalklive daily blog. Follow Lance on Facebook, Twitter and Linked-In